Should markets worry about imported deflation?

With many eyes on China, exporting softer consumer prices from one economy to another is not an ideal solution for central banks facing an uncertain inflationary outlook. After its first rate hike in years, investors could look to Japan...

Should markets worry about imported deflation?

With many eyes on China, exporting softer consumer prices from one economy to another is not an ideal solution for central banks facing an uncertain inflationary outlook. After its first rate hike in years, investors could look to Japan for lessons.

March 26, 2024

Price stability is among primary central bank objectives. However, the entanglement of global market dynamics implies that no economy exists in isolation, meaning one country’s green energy policies, maritime shipping disruptions, or even its artificial intelligence use, becomes equally significant in influencing another country’s inflationary outlook.

Experts often debate about price export mechanisms, evaluating factors such as exchange rates and trade relations in determining how costs in one economy influence other markets. Such discussions are garnering investor attention. Consumer prices in China recently contracted for four consecutive readings, translating into deflationary pricing for economies like the US and EU that import those goods, according to Alicia Garcia Herreo, chief economist for Asia Pacific at Natixis. 

As many countries scramble to reduce inflation rates to hit targets such as 2% in the UK, there is a danger that inflation drops too low. At the same time there is a demand to ignite economic growth. 

Herreo explained that with China representing a fifth of global manufacturing output, the perception of deflationary pricing relief is often misguided, and instead serves as a potential obstacle to global economic growth. 

Mansoor Mohi-Uddin, chief economist at Bank of Singapore, agrees. He explains that falling consumer prices reflect soft demand in the world’s second largest economy. “The China inflation data warrants our attention,” comments Mohi-Uddin, adding “that while a global price shock may help central banks temporarily meet their inflation targets, prolonged weakness in China could lead to inflation targets being undershot around the world.”

And any overcapacity in China could also impact global import markets. 

Lessons from Japan

Japan’s prolong historical deflation trend is frequently cited as a cautionary example, demonstrated by nearly three decades of lacklustre growth. 

Nevertheless, the revival of its main index over the last 18 months also provides a valuable blueprint for taking the necessary steps to rebuild confidence.

“The main lesson from Japan, which is very important to China today, is to act before it is too late,” said Jean-Louis Nakamura, head of conviction equities at Vontobel. “China’s strategic priority of upgrading its manufacturing offering rather than boosting private demand or curbing excessive savings, follows a similar path taken by Japan in the early 1990s,” he explained.

It has been a very long slog for Japan, with finally some light at the end of the tunnel. 

“The takeaway from Japan’s experience is for policymakers to ensure demand revives through fiscal stimulus, [and that] property sector concerns are tackled, and weak banks are closed,” added Bank of Singapore’s Mohi-Uddin, continuing that “without quick action on all these fronts, an economy can fall into a prolonged deflationary slump, as Japan’s three lost decades shows.”

There are good reasons to heed these lessons. Shareholders have welcomed a slew of market friendly measures in Japan, notably share buybacks and dividends. The Nikkei 225 reached its highest level since December 1989, staging a near decade long recovery.

The index has returned almost a fifth since the beginning of the year, fuelled by export companies benefiting from a weaker yen. During its late March meeting, the Bank of Japan ended its negative interest rate policy after eight years, citing that its price stability target of 2% would be achieved.

Decisive action

For China, implementing decisive policies addressing consumer and business confidence reinforces the foundation for long-term economic growth, noted Desmond Fu, portfolio manager at Western Asset Management. While the shift away from property to new engines of growth in green energy, advanced manufacturing and modern infrastructure are positive in the long-term, Fu sees near-term challenges lingering given the drag from property market headwinds.

Extended deflationary periods are a concern not only for central bankers but also for asset allocators and fixed income specialists. Japan’s economy offers a hypothetical roadmap for China’s contracting pricing, however Fu believes that outcomes can differ, as large economies rarely share identical characteristics at each stage of their development.

Experts underscore a strong policy response before the malaise deepens. Although inflation rates diminish purchasing power, deflation perpetuates a downward spiral in pricing that hinders investments and stifles business activities.

The example of Japan demonstrates that falling into deflation is relatively straightforward, but pulling oneself from it is far from easy, only now raising its key target for short-term interest rates from 0% to 0.1%, its first hike since 2007.

With the US Fed set to reduce interest rates in the second half of 2024 and inflation falling across many parts of the world, it will be interesting to see the impact the next six months will have on prices. 

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